There has been one constant theme to all of our six or seven visits to China so far this year, writes Simon Hunt of Simon Hunt Strategic Services.
In each visit we have reported deterioration in economic conditions from the previous
one. The last ten days is no exception. Heavy industry and manufacturing are much weaker than when we were in the country in early July.
Weakness originates from many sources. The external environment is weak, thus exports are poor especially in the appliance sector. Domestic business is soft also. Business is soft because of very high inventories of finished goods (cars, appliances etc.) and semi-finished goods (e.g. copper and copper alloy semis). This stems from continued weakness in real estate even though prices and sales have improved modestly across the country. Surplus housing units represent some nine months of demand excluding the overhang of bought, but unoccupied units. Housing policy could change under the incoming leadership using tax to regulate the market
rather than government decrees. Little will change, however, until the second quarter.
Premier Wen wants to bow out when house prices have fallen to more affordable levels so further weakness seems likely. .
Monetary Policy aimed at curbing future speculation
Monetary policy will change, according to our sources. Households and companies
will receive a real return on their savings thus discouraging speculation in real estate,
manufacturing and heavy industry capacity, commodities etc. under the new leadership. Monetary policy will be prudent, aimed at maintaining liquidity at a stable level rather than to stimulate the economy which has been speculatively driven in recent years. Negative real returns on savings encouraged speculation in most assets. Now this boom is unwinding. First, it was real estate. Now it is surplus manufacturing, heavy industry capacity and materials such as steel.
Banks have to finance a huge inventory of goods lying within the heavy industry, manufacturing and distributional channels. Companies have used every trick to take their inventories off their balance sheets. There are very large stocks of most types of consumer appliances sitting within the distribution channels. The surplus of air conditioning units amounts to about one year of domestic sales.
The consequences of high inventories across nearly all sectors of heavy industry and manufacturing are that many, many companies have very tight cash flows because an inordinate amount is financing inventory. In turn, this means that companies are using their bank credit lines to finance stocks rather than day-to-day working capital. These developments imply that banks’ ability to lend is being constrained by having to roll over loans on which companies have in reality defaulted (steel traders) and to finance the huge pile of inventories.
Capacity utilisation of heavy industry and manufacturing well below par
This leads to another important issue: surplus heavy industry and manufacturing capacity. The IMF recently estimated that average capacity utilisation in manufacturing was 60% implying that many companies are operating well below that level. In some cases we came across average capacity utilisation being below 50%.
Copper wire rod, for example, is a basic industrial sector which is the semi-product from which all wires and cables are drawn. This year average capacity utilisation will be around 50%; and in 2013 and 2014 it will be under 40%. In the power cable sector, for low voltage cables, the surplus capacity is around 30%; for medium voltage cables 50% and for high voltage cables it as much as 60% to 70%.
Restructuring heavy industry and manufacturing will be one of the incoming leadership’s most important issues to resolve. Surplus capacity means that profit margins are squeezed at best and in many cases production lines are loss-making. Local governments are over-stating production and sales and failing to report many companies that have failed.
True growth only 5% to 5.5% in 2012
Investment projects which are approved are designed to add value to the economy. Non-inflation driven growth will slow dramatically, as we have been writing about endlessly. The incoming leadership understands fully the implications of this changing dynamic. Focus will be on quality of growth not quantity. Future growth will be based on domestic consumption, less on investment and exports. Official reported gross domestic product (GDP) will probably be 7.8% to 8% this year. However, we focus on nominal growth and discount that number by an estimated GDP deflator. Last year, the GDP deflator was 7.6%. We guess that it is now running at between 5% to 5.5% but likely to increase in the fourth quarter.
© Simon Hunt Strategic Services